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Only When Pigs Fly-Part 2

I undoubtedly alienated some of our insurance industry subscribers in my February 2001 column. That was not my intent, because life insurance can play an important role in family business owners' estate plans. However, I took issue with a particular agent's proposal to alleviate "Jim's" fear that his children would have to sell his family business stock to pay estate taxes.

My beefs included:

Jim was pressured to make a significant commitment during a traumatic event--a bitter divorce. I believed that he needed to analyze his objectives and needs without the pressure of a purported once-in-a-lifetime opportunity to grab a soon-to-be-discontinued insurance policy.

The agent did tell Jim that the law allows up to 15 years to pay the estate tax. His estate would have dividend and other income that could be used as a funding source over that time period.

The $125,000 annual premium for the proposed $10 million policy would consume all of Jim's available cash. The agent gave no consideration to other uses for those funds. Jim would have to forego peace of mind from investing that money to build lifetime security, as distinguished from security for his heirs.

The proposed insurance policy was designed to provide insurance until age 100, even though a significant aspect of Jim's need was short term--getting his kids through school.

Let's dig a little deeper into why I thought that there was too much fat in the proposed policy. . . why Jim should buy it only when pigs fly.

The proposed premiums happened to equal Jim's available cash flow and the death payoff was the estimated amount of Jim's estate taxes. Was this an amazing coincidence? The answer is in the bowels of the insurance contract.

Most everyone knows that "term insurance" has the cheapest premiums, at least until you get to your upper 60's. There are two reasons. First, actuaries are incredibly good at predicting how many people will die at a particular age. The insurance company simply calculates how much it will need to charge the policyholders in an age group to have enough money to pay the few who die, plus have a little something left over to cover overhead and profits. Percentage wise, more people die starting in their mid-60s, so premiums start to rise dramatically for people approaching their golden years.

Insurance companies started to notice that they were losing customers as they got older because the premiums got so high. It isn't good business to lose customers. So, long ago, someone figured out that an insurance company could stop the mass exodus of aging customers and make more money at the same time by charging more. What a concept! Charge higher prices and keep customers longer!

That same someone managed to convince Uncle Sam that insurance proceeds should be income tax free. It was a match made in heaven. An insurance company could charge young customers more than the required premium and invest the excess without income tax. Those excess premiums, plus the earnings from investing them, could be used to offset the increasing term costs of aging policyholders.

The result was a whole new type of insurance that came to be known as "whole life" insurance. The premium is extremely high and is guaranteed not to increase. Why? Suppose that you guaranteed a customer that you would sell widgets at a fixed price for the next 40 years. Presumably, you would set a high unit price to justify taking the risk of rising production costs. By charging more than your typical price, you would be able to put money aside (plus generate investment income) to cover the potentially greater costs in later years. You'd charge even more because you could not be sure what your investment rate-of-return on the extra premiums might be over such a long time period.

Then life got more complicated because insurance companies had to get more competitive. They started shifting some of the risks back to their customers so that they could charge lower premiums and remain competitive. Risks like how much they could earn on investing the excess premiums, whether the actuaries are right in predicting how many people will die (AIDS created a huge scare for insurance companies a decade ago), etc.

This resulted in what I call a "black box," which is a visual cue for understanding insurance policies. (Just try reading an insurance contract and you'll come up with more descriptive, if less printable, names.)

The black box is simple. You put money in and the insurance company takes money out, often with very broad discretion on its part. In most policies, it's almost an act of faith that the promised proceeds will be in the box when your family opens it shortly after your funeral.

A little reverse engineering from the insurance company's financial perspective can be very revealing. Remember high school algebra? An insurance contract is like an equation with many variables. Although a bit simplistic, the two sides of the equation (cash going into the policy and cash going out) have to be equal over time. It's also a little 1960s transcendentally metaphysical because your black box is blended with other policyholders' black boxes. But, here's the basic concept:

Cash going into the policy:

A. Premiums

B. Earnings from investing any cash remaining after paying the costs listed below.

Cash going out of the policy:

C. Agent's commission

D. Insurance company's overhead costs

E. Insurance company's profit

F. Term insurance cost (meaning the actuarially calculated amounts that the company needs to pay death benefits for the few people in your age group who die each year)

G. Losses from investing any cash remaining in the policy.

Most people don't realize that insurance policies can be individually tailored. There are an infinite number of ways to structure policies. The key from the insurance company's perspective is that the two sides of the equation must balance over time and over their combined customer list. By the way, this is why you can reduce your cost if you choose a company that is particularly picky and does not cover people in risky professions, like skydivers, astronauts and accountants.

The more risk that you are willing to assume, the lower the premium and vice versa. For example, if you agree to assume the risk of the investment rate of return, meaning that you benefit from good investments (B) and suffer the consequences of investment losses (G), voila, you have a "variable" policy. The result is that, if the investments are not as good as expected, you have to pay higher premiums (A) or else there may be nothing for your loving spouse and kids (F) when you die.

Talk to people who bought variable policies in the late 1970s and 1980s when the insurance companies thought they would earn 15% or more on Treasury bonds for the rest of their customers' lives and you'll understand the risk of assuming that the companies will earn what they project.

Shopping for policies based upon price is not the answer. Chances are that the less you pay, the greater the risk that you'll have to pay more later or lose the benefit of the insurance coverage.

Agents use computers to solve the equation by inputting as many variables as possible and telling the computer to make certain assumptions (like the rate-of-return that will be earned on investments within the policy). Input a $125,000 annual premium and then run simulations using various assumptions. Manipulate the commission level, earnings rates, etc. Presto, out pops a $10 million face amount policy, or most any other amount you want. More importantly, they can manipulate how much risk you take and affect the amount of the premium.

The agent had Jim paying a very high premium and, accordingly, Jim assumed very little risk. However, if Jim died early, the insurance company would get to keep the extra money built up in the policy. There are two ways to avoid this outrageous result. The first is mandated by tax rules that prevent Jim and the company from taking excessive advantage of Uncle Sam by loading gobs of cash into the insurance policy and using it as an income-tax-free investment. At some point, you'll see the result of these rules in the policy illustration projections. If you heap too much money in, the tax laws will require an increasing death payout when you get really old.

The other way was used in the proposal for Jim. It is a "rider" to the policy that uses part of the money to buy "paid-up additions." In substance, this is an extra charge to buy more insurance to guarantee Jim that he will get his excess premiums back when he dies (less additional profit for the insurance company and commissions for the agent).

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